Commodity Dependence and Fiscal Capacity Mauricio Cárdenas, Santiago Ramírez, Didem Tuzemen April 1, 2011 Commodity Dependence and Fiscal Capacity Mauricio C´ardenas∗ Santiago Ram´ırezy and Didem Tuzemenz April 1, 2011 Abstract This paper shows that higher commodity dependence reduces the government's incentive to invest in fiscal capacity. After developing a model that makes this prediction, evidence is provided supporting the view that countries more dependent on commodities (whose rents can be easily appropriated by the government, such as oil) have weaker fiscal capacity. Also, fiscal capacity is found to improve less over time in commodity dependent countries relative to countries where commodity exports play a less relevant role. These empirical results are obtained in a panel dataset with estimators that address endogeneity issues. JEL Classification: H40, O10, O13, P48, Q32, Q34 Keywords: natural resources, commodity dependence, fiscal capacity, institutions, development ∗The Brookings Institution. yUniversidad de los Andes. zThe Brookings Institution and The University of Maryland, College Park. 1 1 Introduction Existing research has shown that natural resource wealth of a country can be a curse or a blessing for the country's economic development. A number of studies in the growth literature, most notably Sachs and Warner (1995ab, 1997, 1999, 2001) argue that natural resource abundance has a negative impact on economic growth. In contrast, others point that resource booms during the nineteenth century led to higher economic progress in Latin America, while natural resource wealth in Great Britain and Germany made the industrial revolution possible (Papyrakis and Gerlach, 2003). A more recent success example is Norway, where natural resource wealth has contributed to higher economic growth. These apparently contradictory results suggest that it may not be natural resource wealth or abun- dance alone that drives the development process. What seems to actually matter is how this re- source wealth is utilized. Lane and Tornell (1996, 1999), Baland and Francois (2000), Torvik (2002), Mehlum et al. (2006) and more recently Bhattacharyya and Hodler (2010) show that the impact of natural resource wealth depends mainly on the quality of institutions. The main message of this growing body of literature is that the so-called \resource curse hypothesis" tends to be valid in coun- tries with \grabber-friendly" institutions. The higher the \appropriability" of natural resources by specific groups in the society, the higher the likelihood that they lead to rent-seeking activities and conflicts (Boschini et al., 2007). Robinson et al. (2006) find that countries with strong institutions which promote accountability, political stability and efficient redistribution are likely to benefit from natural resources, rather than suffer from a resource curse. While the effect of institutions on the impact of natural resource wealth or abundance is well- established, the impact of natural resources on institutional development has been less explored. Filling this gap is the main goal of this paper. 2 Acknowledging the endogenous nature of the relationship between resource dependence and institu- tional change, this paper uses a panel data approach that exploits the variability within countries. Flow variables, such as commodity export shares, capture the relative size and variability of resource rents across and within countries that can potentially affect institutional quality. That is, large and volatile resource rents from exports can create \rentier" effects: patronage and rent-seeking behavior by the government officials and groups in power (Sinnot et al., 2010). Although resource abundance (a stock variable) can also have an impact on institutions, this study considers resource dependence, which, as will be discussed below, is a choice variable affected by political incentives, making it more relevant for the analysis of the political economy of natural resources in a panel of countries. The concept of institutions is very broad. For the purposes of the current study, it is appropriate to narrow institutional development to a specific and tractable dimension, which is \state capacity." Furthermore, the focus here is on “fiscal capacity," which refers to the state's ability to raise tax revenue. Although fiscal capacity is related to fiscal institutions, such as administrations like the Internal Revenue Service in the United States, which manage and monitor taxation, the concept captures the broader question of enforceability of taxation. A government may establish a high tax rate, but agents may not comply. Fiscal capacity measures the ability of the state to effectively raise tax revenues. In addition to fiscal capacity, legal state capacity, which refers to the state's ability to protect property rights and support a market economy through \contracting institutions," is also considered. In defining and studying fiscal and legal capacity, this paper builds on the recent work by Besley and Persson (2009), who develop a framework where the policy choices in market regulation and taxation are constrained by state capacity, as well as the economic institutions inherited from the past. The aim of their study is to analyze the determinants of a government's choice to invest in legal 3 and fiscal capacity. They find that fighting external wars, political stability and inclusive political institutions are important elements for stronger state capacity. Additionally, they show that legal and fiscal capacity are complements. Besley and Persson (2010a,b) introduce natural resources in this framework and predict that higher share of natural resource rents in total income leads to weaker state capacity. The current paper complements these earlier efforts to understand the effects of natural resources on investment in state capacity, by developing a detailed theoretical framework and conducting an extensive empirical analysis on the relationship between natural resource dependence and fiscal capacity. The structure of the paper is as follows. In Section 2, a two-period, two-group political economy model is developed. Natural resources generate rents that are received by the government, who in turn decides how to use them. While the rents can be used to pay for investment in fiscal capacity and provision of public goods, they can also be appropriated for private consumption. Investment in fiscal capacity in period 1 determines the maximum enforceable tax rate in period 2. The main finding is that higher natural resource rents decrease the incentive of the government to invest in fiscal capacity. Also, it is shown that higher income inequality amplifies this negative effect of natural resource rents on fiscal capacity investment. Section 3 presents the empirical evidence and answers three questions. First, is the level of fiscal capacity lower in more commodity dependent countries? Second, do more commodity dependent countries invest less in fiscal capacity? Third, does the relationship between fiscal capacity and commodity dependence hold within countries in the short-run? Although there is empirical work on the negative correlation between resource dependence and institutional indicators at the cross-country level (Leite and Weidmann, 1999; Isham et al., 2005), the literature is mainly focused on legal institutions (or legal state capacity), leaving the fiscal 4 dimension unaddressed. Also, with very few exceptions, the existing literature relies solely on cross- country regressions, either by pooling all observations or by estimating panel regressions with random effects. Thus, the results are vulnerable to reverse causality bias. This source of bias arises because measures of resource dependence, such as trade in commodities, production of minerals, or the size of the workforce employed in resource extraction, are also choice variables endogenous to economic, political and institutional factors (Norman, 2009). Therefore, initial institutional conditions likely play an important role in determining the contemporaneous measures of resource dependence. With regards to simultaneity, previous empirical work shows strong evidence that institutional measures, such as state capacity, are persistent over time (C´ardenaset al. 2011), making it necessary to model the dynamic relationship in a panel data framework. Finally, omitted time variant and invariant country characteristics are not taken into account in cross-sectional regressions. A good example of the omitted variables is resource stocks by country (as pointed out by Norman, 2009), which also determine resource dependence measures. Haber and Menaldo (2009) is the only work to analyze the resource curse hypothesis based on a dynamic time-series analysis. Contrary to this paper, their main focus is on the relationship between commodity dependence and the political regime.1 In Section 3, a new panel dataset is used to test whether country-years with higher commodity de- pendence also have lower fiscal capacity levels. To address the aforementioned endogeneity problems associated with OLS regressions, the Arellano and Bover (1995)/Blundell and Bond (1998) System GMM estimator is used. The aim is to expunge from the coefficients the fixed and dynamic effects associated with the flow measures of resource dependence. Also, this methodology allows for the estimation of short-run effects of resource dependence on fiscal capacity, which is a novelty. To assess whether commodity dependent countries invest less in fiscal capacity, the annual panel 1Another